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Inflation is very unpopular. 

The words general price level" in the definition are very important. They mean that 
the term "inflation' applies only to a rise in the average cost of all the things 
we buy. and not to an increase in the price of only one item or class of items 

Of course, a large Increase in the price of one item can sometimes lead to rapid inflation - that is to a 

rapid increase in the general price level. For example, a very rapid nse of oil pnces could lead to a rise 

in the general price level, because oil plays a key role throughout our economy. 

What's wrong with inflation anyway? After aU, if prices 

go up, people who sell things wi!l receive more dollars 

than they did tiefore. That means that incomes go up too. 

Whafs wrong with thatf 

One answer is that not everyone's income goes up as 

much as prices do. People whose incomes rise less than 

prices - or don't rise at all - are hurt by inflation. 

They are unable to buy all the things they used to 

with their income. 

Among those hurt by inflation are fenders who charge 
<nterest rates that are lower than the rate of inflation. 

For example, suppose someone extends a one-year 

loan at an interest rate of 5* and then prices go up lOS 

during the year. The lender will be repaid witn money 

that has less purchasing power that did the money he 

parted with a year earlier. 

Many retired people are hurt by Inflation because their 
pensions don't keep up with increases in the price level. 

Inflation also reduces the value 

of people's savings when price 

increases are lafger than the interest 

rates ttiat people receive on 

their savings accounts. 

Because inflation reduces the value of savings, it gives 
people an incentive to spend rather than save. 

Bv discouraaina saving, inflation can harm the U.S. economy. That s because the economy 

needs a supply of savings to provide the funds for people and businesses to borrow so that 

they can invest in the things that help the U.S- economy grow. 

Inflation can hurt, too, by giving people an incentive to 
invest in ways that don't help the economy grow. 

To enable people to protect the purchasing 

power of their savings, the federal 

government began issuing inflation -indexed 

bonds in 1 997, These bonds allow people to 

lend to the government and then be 

repaid an amount that will rise in relation 

to how much prices rise. 

inflation has other undesirable effects. Increases 
in prices make it more difficult for businesses to plan. 

With (umber prices going up so 

fast, I'm trying to stock up before the 

next price increase. Meanwhile, I'm 

worried that in order to cover my 

J, costs, I'll have to charge such high prices 

for my houses that nobody will 

want to buy Ihcm. 

Inflation feeds on itself. When a flour mill has to pay 

higher prices for wheat, for example, it has to charge 

higher prices for the flour it sells. The bakeries that buy 

the flour then have to charge higher prices for the bread 

and cakes they sell. 

/^ I have to charge you 
/ more dough for the bread 
I because I have to pay a 
\higher price for flour. 

The process can easily become a 

vicious cycle, because when worl(ers 

see the prices they pay going up, 

they'll push for higher pay, and if 

their employers raise their pay, 

they'll have to raise prices to cover 

the increased expense. Some 

people call this process the 

"wage -price spiral." 

AS an "inflationary psychology" sets in, people may try to bea' anticipated 

price increases by buying more of certain items than they need, and they 

may buy other items before they need them. 

When people realize they have overbought, 

they will cut back on their spending, and the 

result can l>e a recession, a downturn in 

economic activity that brings a decline in 

production and an increase in unemployment. 

In fact, since World War II, most recessions have followed 
a sustained increase in ttie core rate of inflation. 

Core inflation refers to increases in ttie general price 
level, excluding food and energy prices. Those prices 

are excluded because they are influenced by 

special - and temporary - factors, such as weather 

conditions or production decisions made by 

oil-exporting countries, so they may present a misleading 

picture of continuing price pressures in the economy 

A very notable episode of tiy per inflation 

occurred in Germany in the 1920s and led 

to great social unrest in that country. In 

the German hyperinflation, the real 

purchasing power of money fell so low 

that the German currency, the mark, 

became a cheaper fuel ttian firewood. 

We have seen that inflation can 

cause uncertainty and economic 

and social instability. But what 

causes inflation? 

The answer is that inflation results 

when there is too much money and 

credit around in relation to the 

amount of goods and services. By 
"money,' we mean cash In circulation 

and the amounts that people and 

businesses have in bank accounts. 

-Credit" refers to the amounts that 

baniis and other lenders have lent or 

have available to lend. 

It's the job of the Federal Reserve System 

(known familiarly as "the Fed") to make sure 

that money and credit don't grow too rapidly 

and lead to inflation. 

The Fed s job of mf luendng money and credit conditions in ttie 

economy often is a balancing act. If money and credit crow too 

rapidly, inflation can result. If they grow too slowly, the result 

can be a recession. 

J^h'lT.hi^T,? ^I^'rh'^f"'* ^'"r"" ""ff^e a recession because people and uu.i,v,..e. 
won t be able to get the loans they need for major purchases at affordable interest rates. 


The Fed has three main monetary policy tools: 
reserve requirements, the discount rate and open market operations. 








Rp«.rvP renuirements are the proportions of deposits that banks must keep either in their own vault or on deposit 

^fh^he Fed («tua ly %«rve r^ulremen^ a'^ly not only to banks but also to other tVP^s onnst,tu Ions that 

accept deposits - credit unions, for example, in this case, though, well use the term banks. ] 

For ewmole if the reserve requirement is 10%, a bank that receives a SlOO checking 
account deS must k^pSIO, either in its own vault or on deposit at the Federal Reserve- 


In practice, the Fed does not change reserve 

requirements very often. In 2008. for example 

the reserve requirement on checking accounts 

had been unchanged at 16S for 14 years 

The discount rate Is the Interest rate thai the Fed charges 
on short-ierm loans to banks (or any reason. 

When the Fed lowers the discount rate, it may be an 

indication that ii would like to see an increase 

in credit - and in economic activity. When the Fed 

raises the discount rate, tt may be issuing a signal that 

It want! to 'cool off the economy," because It is 

concerned about the threat of inflation. 

1 /^ 's 


I , \ guess the Fed 

{ wants to make sure that 
inflation doesn't become 
a problem 

I inflatic 

Open market operations are the monetary policy tool that 

the Fed uses most often. These operations, which are 

carried out by the Federal Reserve Bank of New York on 

behalf of the entire Federal Reserve System, consist 

of buying or selling U,S, government securities from firms 

known as primary dealers. 

When the Fed buys government securities, it pays 

for them by crediting the account that the primary 

dealer's bank has at the Fed. (The bank, in 

turn, credits the primary dealer's account. ) 

When the Fed sells securities, it receives the payment 

from the bank of the buyer. That reduces the total 

amount of funds that banks can lend. 

Because inflation is so hard to stop once 

It gels started, the Fed watches for signs 

of future Inflation, so that it can keep the 

problem contained. 

Federal Reserve economists monitor increases in wages, salaries 

and benefits paid to workers - which reflect the bargaining power 

of employees, rising costs o( medical care and other insurance 

and potential demand for goods and services. 


The Fed keeps track of the value of the 

U.S. dollar relative to the currencies of major 

trading partners. For example, depreciation 

in the dollar reiattve to Japan's currency, 

the yen, increases the price of everything 

imported from Japan. 

Similarly, the Fed v^atches data on the use of manufacturtna 

capacity. When capacity utilization gets very high, companies 

may have to start using less efficient machinery, and that can 

lead to cost and price increases. 

Fiscal policy, which involves the use of 

government spending and taxes, is another 

anti-inflation tool, if inflation threatens, 

the government can cut Its spending and 

thereby reduce demand for the available 

supply of goods and services. 


This isn't a good time 
to start those construction 

projects. We have to 
^orry about inflation. 

i/>f ^ ^ 


To fight inflation, the government could also raise personal 

income taxes, thus reducing spendable income and the 

private demand for goods and services. 

Fiscal policy has some disadvantages, though, as an anli-infiation tool. For 
one thing, it can take a long lime to get a tax or spending bill through Congress. 

Another disadvantage of using government expenditure cuts 

to fight inflation is that it can be wasteful to turn spending on 

and off depending on whether or not inflation is a concern. 


The changes in monetary policy that 

sometimes are needed to reduce inflation 

can impose some short-term pain on the 

economy. For example, to get rid of very 

rapid inflation in the early t980s, the Fed had 

to accept a severe recession m 1981-1982. 

Congress structured the Federal Reserve System 

to shelter it from day-to-day political 

pressures, so that the Fed could pursue policies 

that promote long-term economic grovrth, 

that might be unpopular. 

One factor supporting the Fed's independence is 
that unlike other government agencies, it does 
not depend nn appropriations from Congjess, 

The Fed is self -financing; the interest 
it earns on the U.S. government 

securities it owns provides the income 
needed to carry out its duties. 

Why do we have to use monetary policy to prevent inflation? 

Why can't we prevent inflation directly, by placing limits on 

how much wages and prices rise? 

Also, price and wage controls are very hard to enforce because both 

buyers and sellers (in the case of price controls) and both employers and 

workers (in the case of wage controls) may wish to violate them. 

I don't care what the governmentN 
says. I'm not interested in continuing my] 
practice unless I can charge patients j 
more that I did tast year. ^^/ 


In addition, changes in prices and wages perform a very 

important role in the economy — serving as signals to direct 

labor and other resources where they are needed. 

direct ^^^^y 

Suppose, for example, that there's a shortage 

of computer professionals. To eliminate the 

shortage, employers would offer higher pay 

to attract more people into the field. 

But if the employers weren't allowed to 

offer higher pay, they wouldn't be 
able to get the professionals they need. 

So far, you have read about the problems that inflation can cause and about the ways 
that the government and the Fed can fight inflation. But how do we measure inflation? | 

The government has several measures of inflation. 
The best known is the consumer price index |CPi), 

which measures the prices of items bought by 

consumers in metropolitan areas. Those items cover 

a wide range of goods and services — food, clothing, 

housing, transportation, recreation, laundry 

services and much more. 

The CP! has a direct effect on the lives of many 

individuals and groups. For example, many employers 

ItnW wage increase to how much the CP! goes up. 


"Core inflatfon" measures changes in the general price level 

with food and energy prices excluded, and thus provides 

a more accurate gauge of continuing price pressures. 

Critics also pome out that the CPI is slow to recognize that consumers change their buying patterns 

over time. Specifically, consumers start buying less of items with rapid price rises and more of 

those Items whose prices have not risen rapidly. For example, during years when oil and gas 

prices rise sharply, people find ways to conserve on the use of those items. 

The accuracy with which the CPI measures inflation has 

a significant effect on the budget of the federal 

government. That's because certain benefits, such as 

5ocial security, are based on how much the CP! rises. 


Ttie CPI also affects the revenue side of the federal 

budget. For example, the personal exemptiori under 

the income tax — the amount of tax-free income 

per person to which a family is entitled — 

increases each year, based on the increase in the CPI. 

If the CPI overstates inflation, then the personal 
exemption increases too much each year, and the 
federal government loses tax revenue as a result. 

The increase in ^\ 

the personal exemption \ 

this year wrill save j 

me a few dollars. / 

Whatever its imperfection, the CPI remains the most 

commonly used inflation measure. What does the CPI 

teil us about how well the United States has managed 

to control inflation? In the 1970s and early 1980s, as we 

saw earlier, inflation was often very rapid, even 

reaching double-digit annual rates, but... 


1 4.00% 
12.00% ■ 
10 00% ■ 

a 00% ■ 
6 00% ■ 
4.00% ■ 
2.00% ■ 

0.00% M ii' ' i 


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"The Story of Inflation" uses everyday lan- 
guage and lively illustrations to explain: 

how inflation is defined, 
what causes inflation, 

■ the effects of inflation on 
individuals and the economy, 

I how inflation is measured, and 

I how to prevent inflation. 

For more information about 

New York Fed education 

programs, visit; 

www. n e v(/y o rkf ed . o rg/e d u c a t io n 

To schedule a tour, go to: 



Federal Reserve Bank of New York 

Public Affairs Department 

33 Liberty Street 

NewYork, NY 10045